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August 5, 2013

3 Reasons Why You Need Inflation Protection Now

Deflation, despite dire warnings, is unable to happen anytime soon

All this talk from A. Gary Shilling and others about the coming danger of deflation? Bleh.

That’s the message delivered in a recent whitepaper from Seth Masters.

The chief investment officer of Bernstein Global Wealth Management says deflation, that “persistent drop in the value of assets,” is unlikely any time soon.

Even if it does, Masters notes that investors already protect themselves from deflation through their bond purchases.

“Inflation-protected assets will always have a place in investor’s portfolios because of heightened uncertainty, the availability of better inflation hedges and reasonable costs for inflation protection,” he writes. “While rare, inflationary periods are notoriously difficult to predict. History shows that major bouts of inflation often strike suddenly and without warning, which is what makes inflation particularly dangerous.”

He sees three key reasons why an allocation to inflation protection is even more compelling today: heightened uncertainty, the availability of better inflation hedges, and reasonable costs for inflation protection.

1). More Uncertainty — “Even in the best of times, there’s no reliable forecast of the future path of inflation,” he writes. “Today, however, uncertainty about economic policy and its impact on the price level have become especially high, mainly because no one can confidently predict exactly what will happen as the enormous monetary expansion since the global financial crisis is ultimately unwound.”

On the one hand, some view inflation as inevitable, given the pervasive climate of supportive monetary policy across developed economies, Masters notes. On the other hand, mixed economic data have kept the specter of deflation alive.

“Given the experimental and opportunistic nature of central bank policy measures, economists’ outlook for the breadth of possible inflation outcomes is highly divergent today. This heightens the risk of surprises, and makes inflation protection all the more vital.”

“From a portfolio construction standpoint, inflation hedges can be divided into two categories that complement a traditional portfolio: real bonds that protect risk-mitigating assets such as traditional bonds, and real assets that protect return-seeking assets such as stocks.”

Inflation-linked bonds such as Treasury Inflation-Protected Securities (TIPS) can provide very effective inflation protection for the bond portion of the asset mix. For taxable accounts, he also recommends a muni inflation strategy that layers inflation protection onto a municipal bond portfolio.

“Real assets, such as commodity futures, natural resource stocks, and inflation-sensitive REITs, generate cash flows tightly linked to important components of the overall price level. Shares in mining and other natural resource stocks, as well as some real estate companies, can also benefit from rising prices. Note that most individual real assets are quite volatile, and so it makes sense to diversify a real asset portfolio across a wide range of inflation-sensitive investments. We also see real assets as a good investment.”

3). Reasonable Costs — Reasonable costs represent the final rationale for adopting proactive inflation protection today, Masters concludes. TIPS are fairly priced, with a breakeven rate—or the difference in yield between inflation-protected securities and nominal bonds of the same maturity—of less than 2% for 10-year maturities.

“That’s not much of a premium to purchase inflation protection, especially compared to a high of 2.6% last fall when the Fed’s third round of quantitative easing was announced. Real assets are also sensibly priced relative to their fundamentals.”